As in 2011, executive compensation is the single most important corporate governance issue for companies, boards, and investors for the 2012 proxy season. This Director Notes discusses the evolving analytics and issues around pay for performance (P4P) and suggests ways for companies and their boards to analyze the alignment of P4P, counter negative recommendations by proxy advisers, and draft their proxies to obtain shareholder support for their pay programs.
In 2011, approximately 3,000 companies held their first mandatory shareholder say on pay (SOP) and say on frequency votes; approximately 1,500 “smaller reporting companies” are not required to do so until January 21, 2013. Overall, 42 companies that held SOP votes in 2011 received less than 50 percent shareholder support. More than 90 percent of companies received shareholder support of 70 percent or higher, and more than 70 percent received shareholder support of 90 percent or higher. On the issue of say on frequency, shareholders at more than 75 percent of companies supported annual SOP votes, while shareholders at a majority of the remaining companies supported triennial votes, and a few supported biennial votes. Following the votes, the vast majority of companies adopted the vote frequency preference supported by a plurality of their shareholders.
One unexpected development during the 2011 proxy season was the large volume of publicly filed disputations between public companies and Institutional Shareholder Services (ISS) and Glass Lewis, the two most influential U.S. proxy advisers, over their negative SOP recommendations. While some of the negative recommendations and the controversies that followed were related to pay practices labeled “problematic” or “egregious” by the proxy advisers, most of the negative recommendations and controversies stemmed from negative recommendations based on those proxy advisers’ P4P voting policies.
Proxy Season 2012
As of March 28, 2012, 161 companies had held SOP votes in 2012. These votes generally received slightly greater shareholder support than they had in 2011. A few companies with failed votes in 2011 revamped their pay plans and disclosure dramatically and received strong shareholder support; however, shareholder support at a few other companies slipped badly.
At the beginning of 2012, election year politics, the Occupy Wall Street movement, and a trend toward more aggressive limits on compensation in the United Kingdom and Europe has intensified the scrutiny and pressures faced by U.S. companies over their executive pay. Based on proxies, supplemental proxy materials, and Form 8-Ks filed with the Securities and Exchange Commission (SEC) for SOP votes in 2012, it is clear that P4P will be an even bigger issue in 2012 for several important reasons.
- 1. Most companies that are required to hold SOP votes (generally Russell 3000 companies) have largely eliminated pay practices that proxy advisers and shareholders view as “problematic” or “egregious” (such as large perquisites, excessive severance pay, Internal Revenue Code Section 280G “golden parachute” payment tax gross ups, and other tax reimbursements).
- 2. There appears to be a growing recognition among institutional investors and boards that the single most important issue in the executive compensation arena for shareholders is P4P. In other words, the notion that short-term and long-term incentive compensation (1) should be designed to encourage behavior that drives a company’s financial performance and results in favorable shareholder returns over time, and (2) should be aligned with the company’s financial performance and shareholder returns, as well as those of its peer companies, over time.
- 3. There is evidence that institutional shareholders are interested in more sophisticated and holistic methods for analyzing P4P than those used by the proxy advisers in the past.
- 4. In perhaps the most important development, proxy advisers, compensation consultants and others are focusing on P4P like never before, as they actively compete for market share and seek to help investors and companies analyze P4P with more sophisticated models and holistic analyses than in the past.
All of these and other developments ensure that 2012 will be the year of P4P.
As in 2011, P4P will undoubtedly generate substantial controversy as companies challenge the proxy advisers’ P4P analytics and vote recommendations. However, there are signs that the quality of the dialogue has improved, and there is the anticipation that this season will shed more light on the subject than occurred in 2011. At this early stage, we are hopeful that this season will move the dialogue on executive compensation and P4P toward a more holistic analysis and away from check-the-box, one-sizefits- all methodologies that have failed to account for all of the differences between companies, their strategic and tactical business objectives, their current situations and those of their market competitors, and the knowledgeable and tailored judgments made by many boards. We are hopeful that the SEC staff will study P4P ideas in the marketplace, including the movement toward more sophisticated analyses, and adopt a flexible and holistic approach when it drafts the Dodd-Frank rules on “pay versus performance,” which are expected to be proposed by the end of June and finalized before proxy season 2013.
P4P Viewed Through Two Lenses
Responding to the controversies over P4P in 2011 and the growing interest in more holistic approaches to P4P, some early 2012 proxy filers have analyzed and presented their P4P stories in new and persuasive ways. The controversies over P4P reveal two distinct perspectives that are used to assess P4P, both of which should be analyzed separately. On one hand, there is the perspective of boards and compensation committees looking ahead prospectively as they design pay plans and create compensation opportunities to encourage the desired performance. On the other hand, there is the perspective of the investors, proxy advisers, boards, and compensation committees looking in the rearview mirror retrospectively to assess whether executive pay during a specified period was in fact aligned with the company’s actual financial performance and the returns earned by shareholders. To use another analogy, the former, prospective lens focuses on how the performance pudding is made; the second, retrospective lens focuses on the proof of the pudding after it has been made.
In light of these two very distinct P4P lenses, public companies should think about the questions raised by each separately and be prepared to address both positions in their proxies and engagement with shareholders; however, the analysis below does not concentrate on the prospective lens because it is not the focus of the proxy advisers in their 2012 P4P evaluations. Nevertheless, understanding the prospective P4P lens is important because shareholders should know the position of boards and compensation committees when they design pay plans and look at the past years’ performance to create executive pay opportunities for the next year. The prospective view should also be considered because proxy advisers often conflate the two issues by stating that pay opportunities created by the company should be used to determine P4P alignment because that is what the company thinks the executives “ought to receive,” overlooking the important fact that pay opportunities generally are subject to performance goals that are generally intended to be aligned with shareholder returns.
P4P Voting Policies: ISS
The 2011 ISS policy During the 2011 proxy season, the majority of ISS’s negative recommendations on SOP advisory votes were triggered by its assessment of P4P “disconnects” between company performance and executive compensation. ISS’s 2011 policy used a two-prong test that measured P4P alignment by analyzing one- and three-year total shareholder return (TSR) (stock price appreciation plus reinvested dividends) relative to the TSRs of all Russell 3000 companies in the same four-digit Global Industry Classification Standard (GICS) industry group, as well as the total compensation of a chief executive officer (CEO) who served for at least two fiscal years. Under the first prong, a company was generally deemed to have a “performance” problem if its TSR was below the median of its industry group over both the previous one- and three-year periods. If this was the case, the company would be analyzed under the second prong of the ISS test, which was a rudimentary determination of changes in the CEO’s total direct compensation from 2009 to 2010. After applying this second prong, ISS generally would conclude that the company had a P4P “disconnect” if, compared to the prior year, the CEO’s compensation had not been significantly reduced in 2010.
The 2011 policy was heavily criticized by companies and others for several reasons. First, it focused on relatively short-term performance and CEO compensation for one year relative to the CEO’s compensation during the prior year. Second, a company’s TSR results were measured against a “peer group” based on four-digit GICS categories, which consisted of large groups of companies, not true capital market or employment market peers. Third, the only company performance evaluated was TSR, not other important measures of financial performance (i.e., changes in revenue; net income earnings; earnings before interest, taxes, depreciation, and amortization (EBITDA); return on equity; and return on capital). Fourth, the policy determined CEO pay based on proxy summary compensation table (SCT) values that value equity and long-term incentive awards as of the date of grant, not the value of the awards actually realized by the CEO in terms of awards vested or paid. Further, the value of stock option and other equity grants was based on ISS’s Black-Scholes assumptions and calculations (not those used by the company for financial statement and SEC reporting purposes), which generally overstate the value of the CEO’s awards. ISS’s new 2012 P4P policy addresses some but not all of these problems.
The 2012 ISS policy In response to the criticisms of its 2011 policy, ISS’s updated 2012 policy, which is in effect for annual meetings held on or after February 1, 2012, focuses less on below-median performance, looks at longer-term alignment, and uses new peer groups. Under the new policy, ISS will conduct an annual P4P analysis to identify the degree of alignment between pay and performance over a longer period for most public companies, not just those below the median in their TSR scores. For Russell 3000 companies, two quantitative factors—peer group alignment and absolute alignment—are evaluated on an objective basis. If these evaluations are problematic, then ISS applies a further qualitative, or subjective, evaluation.
More specifically, ISS’s new quantitative P4P tests determine the alignment between executive pay and company performance based on three measures: two relative measures, which evaluate P4P alignment against an ISSgenerated set of peer companies, and one absolute measure, which evaluates a company’s P4P without regard to that of other companies. These three quantitative measures are:
- Relative degree of alignment (RDA) The degree of alignment within the company’s ISS peer group of the company’s rank for both TSR and the CEO’s total pay, as measured over the prior one- and three-year periods (weighted 40 percent and 60 percent, respectively).
- Multiple of median (MOM) The multiple of the CEO’s total pay relative to the ISS peer group median CEO pay.
- Pay-TSR alignment (PTA) The difference between the trend in the CEO’s annual pay and the company’s annualized TSR, measured over the prior five fiscal years.
The peer group alignment measures (the RDA and MOM tests) emphasize longer-term alignment by considering the degree of alignment relative to the company’s peer group of both the company’s ranks for TSR and the CEO’s total pay measured over one- and three-year periods (weighted 40 percent and 60 percent, respectively), as well as the multiple of the CEO’s total pay relative to the peer group median. The new ISS “peer group” consists of 14 to 24 companies (rather than the entire GICS industry group) that are similar in revenue and asset size and are selected using market cap, revenue (or assets for financial companies), and GICS industry group. In its relative alignment analysis, ISS will typically use a chart similar to Chart 1 to demonstrate the degree of alignment between a company’s pay and its performance.
Chart 1 displays company pay and performance as percentages, both for the relevant company (indicated by a black triangle) and its peers (each indicated by a blue diamond). The shaded gray portion of the graph represents the area in which pay and performance are aligned. Whether a company falls outside this range is one of the factors that will be considered during ISS’s overall P4P assessment.
ISS’s absolute alignment measure (the PTA test) analyzes the difference between the trend in the CEO’s annual pay and the company’s annualized year-end TSR measured over the prior five fiscal years. Unlike ISS’s 2011 policy, total CEO pay is examined for each relevant year, based on the compensation of the CEO serving at the end of the year, and CEO pay is based on SCT values without regard to whether the CEO remains the same or changes from year to year. Below right is an example of the chart ISS generally uses to analyze absolute alignment:
Chart 2 compares the company’s CEO pay to the company’s TSR over the previous five years, measuring how annual company performance compares to annual pay and the general trend in pay and performance alignment over that period. Once ISS’s analysis is complete, a final score is assigned to each company based on outcomes of the three quantitative tests, which ISS uses to determine whether the company’s P4P demonstrates a “high,” “medium,” or “low” level of concern (i.e., the degree to which the company is likely to have a P4P “disconnect”).
If the quantitative tests described above indicate unsatisfactory long-term P4P alignment (or, for non-Russell 3000 companies, indicate misaligned pay and performance), ISS will analyze the following qualitative factors to determine how pay encourages or undermines the creation of longterm value and alignment with shareholder interests. If enough mitigating factors are present, this will result in a positive P4P result notwithstanding unsatisfactory results on the quantitative tests:
- The ratio of performance-based to time-based equity awards
- The ratio of performance-based to total compensation
- Completeness of the company’s executive compensation disclosure and the rigor of performance goals
- Peer group benchmarking practices
- Actual results of financial and operational metrics (including growth in revenue, profit, and cash flow (absolute and as compared to peers))
- Special circumstances, such as nonannual equity grant practices or the effect of a new CEO during the prior fiscal year
- Any other relevant factors
ICS Corporate Services (an affiliate of ISS that provides consulting services to companies) and many compensation consulting firms are now simulating ISS’s P4P analysis (including the new peer groups) to show how ISS proxy advisers are likely to apply ISS’s new P4P policy during the 2012 proxy season.
Problems with the 2012 policy Despite these attempts to address investor and company criticisms of its 2011 P4P policy, the new ISS policy perpetuates several of the problems of its prior P4P policy, such as analyzing relative performance based on relatively arbitrary GICS industry groups, which largely consist of companies that are not “peers”; applying a single approach to companies throughout various industries that may be better suited for different types of performance-pay alignment analytics; and reliance on grant date values for equity and long-term incentive compensation awards without regard to amounts actually paid or amounts that could be earned. In addition, the 2012 policy continues to focus exclusively on CEO compensation to assess P4P.
The greatest concern, however, of many companies and their advisors and investors is that the new policy continues to quantify pay based on “pay opportunity,” as reflected in the SCT, rather than on realizable or realized pay. The reliance on pay opportunity has been widely criticized by investors and companies as providing an inaccurate picture of the compensation taken home by the CEO during the year, as well as for its reliance on Black-Scholes valuations of equity awards, which often overstate or underestimate the value of expected compensation. Notably, and as discussed in further detail below, the pay and performance of companies that are deemed to have unsatisfactory P4P alignment under ISS’s methodology (e.g., high pay opportunity and low company performance), are often aligned when realizable pay, rather than pay opportunity, is analyzed.
The new policy also creates timing disconnects for many companies, particularly those that file proxy statements early in the season. In such cases, it appears that the company’s 2011 pay will be compared with that of its ISS peer group for 2010 if the peers have not yet reported their 2011 pay. In addition, it is possible that pay and TSRs may be mismatched depending on year ends, such as by using peer group 2010 pay measured against their 2011 TSRs. Finally, ISS’s new and more complex quantitative tests will likely put substantial pressure on ISS to load and properly analyze and report CEO pay and TSR data on more than 3,000 companies, which will be interesting to watch as the shareholder meeting calendar becomes more crowded.
P4P Voting Policies: Glass Lewis
Historical policy Glass Lewis’s P4P voting policy has historically been substantially less transparent than the ISS policy. In 2011, Glass Lewis said that its P4P policy analyzed seven factors of shareholder wealth and business performance (change in stock price, change in book value per share, change in operating cash flow, EPS growth, total shareholder return, return on equity, and return on assets) over one-, two-, and three-year periods, and two compensation points—total compensation for the CEO and the top five executives compared against the performance and compensation of the issuer’s peer companies. However, the policy has been opaque, and its application has been difficult to assess largely because Glass Lewis has not publicly disclosed its P4P methodology in any real detail. In 2011, as in prior years, the only clues about its methodology came from Glass Lewis’s boilerplate proxy report statements that its assessments of companies’ P4P were based on a proprietary P4P model that used 36 measurement points. Each company was assigned a P4P letter grade ranging from A to F, reflecting Glass Lewis’s determination as to whether the company’s pay aligned with its performance. While the Glass Lewis analytics may have been more holistic than those used by ISS, its lack of transparency has left much to be desired.
2012 policy In early February 2012, Glass Lewis and Equilar, which provides executive compensation data and analytical services to companies, investors, and compensation consultants, announced a partnership to provide investors and companies with an enhanced compensation analysis for analytical and proxy voting purposes, especially with respect to P4P. Glass Lewis announced that it will make its P4P proxy voting recommendations based on the partnership’s new analytics for proxies for shareholder meetings held after June 30, 2012. Glass Lewis’ P4P model will be updated to incorporate Equilar’s “realizable” pay data, which focuses on earned pay rather than pay opportunity. As discussed in detail later, realizable pay focuses on current stock prices and payouts from long-term incentives to provide an estimate of the actual compensation that executives realized, or could realize, on their stock grants and by exercising their options and stock appreciation rights, rather than on grant date values that over- or underestimate the value of awards or compensation that were in fact delivered.
In a second major change, the new Glass Lewis model will also rely on “market-based” peer groups developed using Equilar’s algorithms for analyzing publicly-disclosed relationships among companies, hopefully to create strong and accurate peer groups. Unlike ISS’s peer group methodology, which relies on fixed GICS classifications and company size, largely based on revenue, Equilar’s methodology is based on a host of factors that link public companies to one another. These factors include the companies in the publicly disclosed peer groups, the similarities between companies, and the geography, industry, and size of the companies. Equilar then selects companies that have the strongest relationship with the company in question and then provides Glass Lewis with the peer groups for each issuer undergoing a P4P analysis. Although the effect of this enhanced policy is currently unknown, the new analytics may increase the transparency of Glass Lewis’s P4P methodology and could provide companies and shareholders with more accurate and helpful guidance as to the alignment of company performance and compensation.
Early 2012 Investor Response
In response to the controversy over P4P in 2011, institutional investors appear to be moving toward more holistic P4P analyses. In early January 2012, the Council of Institutional Investors (CII) became the first client to subscribe to Equilar’s P4P Analytics—this method, as discussed above, uses a market-based algorithm to determine peer companies and a realizable pay methodology for determining the value of equity and long-term incentive awards—as more accurate and objective measures of peers and pay.
Other investors have embraced the concept that executive compensation and analyzing P4P can and should vary between companies. In other words, what works for one company in terms of pay-performance alignment and encouraging executives may not work for another. Recognizing the “unique nature of compensation” and the lack of a “one-size-fits-all” solution to executive compensation, the California State Teachers’ Retirement System (CalSTRS) affirmed that it intends to evaluate pay holistically, analyzing not only the alignment between pay and performance, but also corporate peer groups, problematic pay practices, and disclosures. Similarly, BlackRock stated that it will use a “value-focused engagement” approach to governance that involves examining a company’s specific positions, and that it is willing to support “unconventional approaches” if they serve the interests of long-term shareholders. Recently, the Wall Street Journal reported that the California Public Employees’ Retirement System (CalPERS) accepted The Walt Disney Company’s arguments for the alignment of its pay and performance, notwithstanding ISS’s conclusion to the contrary and negative say on pay vote recommendation. It would not be surprising to see more investors and their representatives do the same.
P4P Analytics and Arguments in 2012 Proxies
Proxy filings for early 2012 meetings are proving the importance of the P4P issue, arguing company cases for P4P alignment with more precision and force than ever before, and challenging the proxy advisers’ P4P analytics, both anticipatorily and in response to negative vote recommendations in supplemental proxy filings. Not surprisingly, these filings focus on the meanings of pay, performance, and peer groups.
The analysis of “pay” in P4P When the SEC amended its rules on the presentation of executive compensation in 2006 by introducing the Compensation Discussion & Analysis (CD&A) and new tables including the SCT, it said that the SCT would continue to serve as the principal disclosure vehicle regarding executive compensation, and the total compensation column would simplify the presentation of the previous tables. However, under the amended rules, the SCT contains a mix of realized pay (such as base salary, short-term nonequity incentive plan amounts, and long-term nonequity incentive plan amounts) and pay opportunities (such as equity and cash-based long-term incentive awards), the latter of which will only be realized if the company’s stock appreciates in value (such as for stock option awards) or performance targets are attained (such as for performance shares or performance-based long-term incentive awards). The impact of the fundamental disconnects in the SCT itself has been exacerbated by proxy advisers’ use of the table to determine P4P alignment. The emerging good news is that institutional shareholders appear to be unpacking the SCT numbers in analyzing P4P, and companies are drafting their proxy statements to include disaggregated SCT quantitative information not required by the SEC’s rules to help shareholders better understand their P4P alignment.
The use of “realizable pay” An important approach that companies have adopted with growing frequency is to analyze their pay in P4P based on “realizable pay” and not on the pay opportunities reflected by the SCT. Although companies and compensation consultants have different ways of calculating realizable pay, it is based on the general principle that pay should be calculated based on actual compensation earned during the subject period and amounts that can be realized (e.g., reflecting the value of any equity and long-term incentive awards granted during the period in question, based on actual stock prices and company financial performance). Companies that include realizable pay information in their proxy statements for equity awards argue that realizable pay reflects the real value of the equity awards granted, and they say it is the most responsive measure to the increases and decreases of stock price changes. A study by compensation consulting firm Pay Governance found “strong alignment between companies’ stock price performance and realizable CEO pay: CEOs at high-performance companies earned higher realizable pay than their counterparts at poorly performing companies… [Pay Governance believes that] realizable pay is the best measure for assessing the alignment that we advocate, as it is a truer representation of the value most likely attainable by an executive in a given time/performance period than is pay opportunity or realized pay.” Pay Governance also found that more than 10 percent of the companies in its test sample that would have had a P4P disconnect under ISS’s RDA test based on pay opportunity would have actually had realizable pay that was aligned with company performance.
Some companies illustrate P4P alignment based on realizable pay by presenting the company’s P4P alignment relative to that of its peer group. For example, the proxy statement filed by ABM Industries, Inc. on February 6, 2012, includes Chart 3, which shows realizable pay compared to its three-year TSR.
The ABM graph performs several different tasks. First, it looks at three-year realizable pay, which ABM defines as:
(1) actual base salary paid over the three-year period, (2) actual short-term incentive payouts over the three-year period, and (3) the December 31, 2010, market value of: (A) in-themoney value of stock options granted over the three-year period, (B) time-based restricted stock awards granted over the three-year period, and (C) performance-based incentives (i) as paid for grant cycles beginning and ending between 2008–2010, and (ii) as granted for performance cycles that have not yet been completed, assuming target performance based on actual stock prices as of the end of the period, not as of the date of grant.
Second, it shows ABM’s named executive officers’ realizable pay during the three-year period compared to the realizable pay of peer group company executives during that same period (ABM’s named executive officers’ realizable pay is at around 50th percentile of its peer group companies’ named executive officers’ realizable pay). Third, it shows ABM’s three-year TSR compared to the three-year TSR of its peer group companies (ABM’s threeyear TSR is above the 75th percentile of its peer group companies). Finally, it shows that, among its peer group companies, only six companies had a better P4P ratio (i.e., higher performance with lower named executive officer compensation).
In another example of a P4P analysis using realizable pay, Aecom Technology Corp. disclosed the absolute comparison between its realizable pay and company performance. Aecom’s proxy statement, filed January 27, 2012, includes two bar graphs showing its CEO’s realizable pay compared to its four-year earnings before interest, taxes, and amortization (EBITA) and EPS performance, as shown below.
Aecom defines realizable total compensation as salary paid, actual annual incentive earned, and the value of all equity incentives granted over the last four years based on a 2011 fiscal-year-end stock price. The bar graphs in Chart 4 illustrate several concepts. First, they show that total compensation amounts calculated with grant date fair values (or grant date total compensation) were significantly higher than the total compensation amounts calculated with realizable values (or realizable total compensation). Second, they show that even though grant date total compensation increased significantly every year, the realizable total compensation only increased modestly (and decreased during 2009). Third, they show that as company’s financial performance (as measured by EBITA and EPS) improved, CEO realizable total compensation increased only modestly or decreased. As discussed below, this is an important concept, as there is more to company performance than TSR.
Other companies have shown their realizable pay numbers as compared to their SCT numbers. For example, Staples included tables in its 2011 proxy statement in support of its contention that realizable pay was the most appropriate measure for assessing pay for performance. Table 2 provides Staples’ calculations of how its CEO total “actual” compensation was determined.
If Staples’ shareholders had compared the “Total Actual Pay” numbers to Staples’ SCT total compensation numbers, they would have seen that the CEO’s pay was $6,144,422 (realizable) in 2008, instead of $12,636,795 (as shown in the SCT); $11,962,056 in 2009, instead of $10,759,001; and $10,819,582, instead of $15,165,193 in 2010.
Of course, there are limitations to the realizable pay approach. It is still a hypothetical measure of pay, based on a measure of pay at a specific point in time of the amount that may be realized by the executive in the future. Realizable pay, therefore, does not take into account numerous future events that may occur (e.g., forfeiture of compensation due to unattained performance goals) and that could determine the amount of actual pay. Another common concern about the realizable pay approach is the difficulty stockholders may have comparing companies because of the various ways of calculating and defining realizable pay. Over time this should be less problematic as companies and their pay consultants begin to develop consensus around these issues.
The use of “realized pay” A second approach adopted by some companies to tell their P4P stories is the “realized pay” approach. The realized pay approach is the easiest to understand, since it measures the compensation an executive actually received during the year in question. However, differences exist in companies’ approaches to calculating realized pay on such issues as whether to include the value of stock option shares vested during the subject year and whether or not the executive exercised the stock option. Some companies argue that realized pay is the best approach to determine the relationship between compensation and company performance over a specific period. For example, CalSTRS has stated, “In the end, you can’t take Black-Scholes to the bank,” and it also said it would like to see additional tables in proxy statements that describe realized pay to support better alignment with performance.
Some companies that have adopted the realized pay approach prefer to show total realized pay as a supplement to the SCT, using the same format. For example, Hewlett-Packard’s 2012 proxy statement includes a table showing realized pay.
As compared to the total column in H-P’s SCT, the total compensation realized tells a much different story. For example, Ms. Lesjak’s 2011 and 2010 total compensation shown in the SCT is $11,005,978 and $8,096,968, respectively, as compared to $2,793,395 and $10,162,976 for the same years in the total compensation realized table. The realized pay table shows the impact that the company’s below-target financial performance in fiscal 2011 had on realized compensation.
Other companies illustrate realized pay as compared to company performance, both in absolute and relative terms. For example, Baker Hughes Inc. included explanations and charts in its proxy statement (Charts 5 and 6).
Johnson & Johnson’s proxy statement also illustrated realized pay as compared to company performance, as measured by TSR. The graph and table both compare its CEO’s realized pay and total SCT compensation to TSR for 2007–2011.
The Johnson & Johnson line graph in Chart 7 illustrates clearly that there is P4P alignment when looking at realized pay, compared to the company’s TSR. It also distinctly shows that the pay opportunity shown in the SCT is not a good measure of P4P alignment.
As with the realizable pay approach, there are limitations to the realized pay approach. Again, there may be difficulty in comparing companies because of the different ways of defining and calculating realized pay. Some companies include in their calculations the value of stock options upon a specified date (e.g., vesting date or fiscal year-end date), whether or not exercised; therefore, even though the executive is shown to have realized the value of such options, if the executive has not yet exercised the option, the value of such option may decrease or increase in future years. Other companies do not include the value of stock options if they are not exercised, leading some to argue that not including the values of such vested stock options unjustly underreports the executive’s compensation.
The Analysis of “Performance” in P4P
The use of TSR While the ISS and Glass Lewis P4P voting policies primarily use TSR movement to determine company performance during any relevant period of time, TSR does not tell the whole story of company performance. Many argue that there are many companies with stock prices lower than they should be because of undervaluation in the stock market. For instance, small-cap companies experience low trading volumes and TSR arguably does not reflect the company’s performance during the period of time in question. Still other companies have experienced favorable company financial performances, but TSR may not show such company financial performance due to the macroeconomic climate or stock market perceptions, largely outside of the companies’ and executives’ control. For example, Piedmont Natural Gas Company, Inc.’s communication with certain shareholders, filed with the SEC on February 22, 2012, argues that its 2008 stock price should not be the starting point of the three-year TSR measure because the financial crisis during that period of time drove their stock prices to skyrocket due to the “flight to quality” that occurred at that time.
The use of financial performance metrics (often with TSR) Accordingly, many companies argue that, although TSR should be a factor in analyzing the performance of a company, other factors should also be included, such as whether revenue, net income, EBITDA, earnings per share or return on capital or equity increased during the relevant period. These companies contend that, over time, improved company financial performance measured by metrics such as these should and will result in the creation of shareholder value. In the meantime, shareholders should not penalize a company for alleged P4P disconnects that result from sound policies and pay plans that were designed to encourage improvements on these targeted metrics, but which may not be rewarded by fickle and volatile stock markets. These companies further argue that shareholders should not focus exclusively on TSR, but on whether the company’s compensation program aligns the attainment of important financial performance objectives with executive compensation. Still other companies argue that longer TSR performance should be the measure and not the oneor three-year TSR. Longer TSR performance calculations reflect long-term sustainable value as opposed to shortterm anomalies in stock price.
The P4P “peer group”
The peer group to which a company is compared can dramatically affect the outcome of any P4P analysis. As discussed above, ISS will determine a company’s peer group in 2012 by selecting 14 to 24 companies that are similar in revenue (or assets for financial companies) and market cap within the company’s GICS industry group. If the peer group consists of companies that are comparatively too small in terms of market cap, net income, or other company financial measures or too different in terms of industry, the P4P analysis may be skewed unfavorably against the company because smaller companies or companies in different industries may have lower executive compensation numbers. Some companies are reaching out to shareholders to explain their view that the peer group being used by ISS for its P4P analysis isn’t appropriate.
For example, Qualcomm sent a letter to shareholders, filed with the SEC on February 21, 2012, detailing its view on why the ISS peer group pay should not be compared to Qualcomm’s pay. The company takes “issue with the peer group selected by ISS to benchmark our CEO compensation and believe that it fails to recognize that Qualcomm is one of the largest companies in the United States by market capitalization value, and fails to recognize our unique business structure.” The letter continued, “Qualcomm is among the largest and most profitable companies in the S&P 500 and is significantly larger than most companies in the ISS comparator group.” In a table format, Qualcomm disclosed that in market capitalization and in net income in terms of dollars, it was ranked second out of the 15 ISS peer group companies. Using its internal compensation peer group, Qualcomm ranked eleventh out of the 28 peer group companies on both measures. Qualcomm reasoned that because of ISS’ emphasis on revenue, it ranked as one of the largest companies on all key size measures in the ISS peer group; therefore, “it is no surprise that our CEO’s compensation was viewed as being relatively higher.” If ISS had used Qualcomm’s internal compensation peer group, the letter stated, the company would have passed all three ISS quantitative tests with “low” concern.
The Walt Disney Company also sent a letter to its shareholders, filed with the SEC on March 1, 2012, criticizing ISS’s peer group analysis and arguing that the only companies it should be compared to are “the five major publiclyheld entertainment companies whose management issues and challenges most closely resemble those of The Walt Disney Company.” “ISS has off-handedly and improperly dismissed the board’s judgment that the five media companies with whom the company competes for talent are the most relevant points of comparison to assess performance and to structure a compensation package to retain a CEO,” the letter stated. “ISS’s position is out of touch with the reality that no company could attract and retain top management if its compensation packages are not competitive with those offered by the companies with whom it competes for talent.”
Piedmont Natural Gas Company and National Fuel Gas Company also sent letters to shareholders arguing that ISS takes too simplistic an approach to its peer group formation and does not take into account the specific industries in which the companies are involved. Piedmont noted that its ISS peer group includes companies that are not in the same line of business. “We believe that several of the peer companies selected by ISS are diversified energy companies with operations outside of natural gas distribution and therefore are not readily comparable to Piedmont,” the letter stated. “Given the importance of the selected peer group under ISS’ new pay for performance analysis, we believe Piedmont’s shareholders deserve an appropriate comparison group for measuring long-term shareholder value creation.” National Fuel argued that using the GICS classification to determine peer group companies is fatally simplistic because it does not “accurately capture the nature of an entity that operates in multiple lines of business that each have a significant contribution to its financial and share price performance… National Fuel’s current GICS classification is reflective of its historic origin as a Utility… [and] does not reflect the company’s transformation into a company with an oil and gas Exploration and Production business segment.”
Another argument against ISS peer group data analysis is based on timing differences. National Fuel argued that ISS’ P4P analysis is internally flawed because the compensation used in its peer group analysis is derived from proxy statement filings, which may be from the previous year. This causes a disconnect because ISS is comparing current year compensation in the subject company to prior year compensation in peer group companies. National Fuel stated, “for at least 77 percent of the ISS selected peer group, the [ISS] Report compares 2010 compensation to 2011 performance, while comparing National Fuel’s 2011 compensation to its performance in fiscal 2011… if the apples to oranges comparison is intended, then the report should clearly draw attention to that fact and explain it.” Adobe Systems Inc. also argued in a letter to its shareholders that “the ISS report compares compensation data primarily from calendar year 2010 for all of ISS’ selected peer companies to primarily their 2011 total stockholder return… in comparison, ISS compares our fiscal 2011 compensation to our 2011 TSR performance” The letter continues, “This asymmetry leads to results that are decidedly skewed, in part, due to significant improvements in economic conditions since 2010. ISS’ report fails to draw attention to this apples-to-oranges comparison and neglects to explain its effects.”
Given the influence of ISS and Glass Lewis recommendations on SOP vote results and the increased focus on P4P linkages, companies should consider whether they would benefit from including additional disclosure of the reasons for their internal peer group selection for comparing performance and pay. Even though ISS or Glass Lewis may use a different peer group, a strong internal peer group analysis could help shareholders to take a more critical look at the question than if the company makes no such analysis, and set the stage for the company to file supplementary proxy materials if necessary.
Some Practical P4P Recommendations for Companies
In view of the growing importance of P4P, boards and compensation committees ought to consider the following steps to help support their P4P stories and garner support for their say–on-pay votes:
- Understand the short- and long-term strategic and tactical objectives of the company, based on its individual circumstances, as well as the management performance objectives necessary to achieve the company’s business and financial objectives, and design short- and long-term executive compensation plans that encourage the executives to achieve those objectives.
- At least annually, evaluate whether the company’s business and financial objectives have changed or should be revised, whether the company’s pay plans are working as intended, and whether/how they should be adjusted to work better to achieve the desired objectives.
- Convey concisely and persuasively in the CD&A that P4P is important in setting compensation, and that the company actively reviews and adjusts its performance plans based on changing circumstances.
- Evaluate the performance of the company’s incentive plans at least annually over a longer period (at least three to five years) to determine the extent to which the realizable pay generated for management is aligned with the actual achievement of business and financial objectives and the creation of shareholder value, as well how the company’s realizable pay, financial performance, and value creation align with its peers.
- Perform or commission simulations of ISS and/or Glass Lewis P4P tests to determine their likely determinations and recommendations to shareholders.
- Review disclosure by peer group companies about their P4P alignment.
- Draft clear, concise descriptions in the executive summary portion of the CD&A of business, financial, and shareholder return performance; how pay plans are designed to drive these; and how the plans have generated realizable pay over time that is aligned with the company’s performance and the performance and pay of its peers.
- Use plain English, charts, and graphs in the CD&A executive summary to tell the company’s P4P story.
- In the CD&A, actively anticipate any likely P4P objections by the proxy advisers to lay the groundwork for shareholder engagement and supplemental proxy materials that dispute the advisers if necessary.
- Engage directly with shareholders on P4P matters to the extent possible.
- Be prepared to file supplemental proxy materials in response to negative recommendations from the proxy advisers.